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BlackRock Faults Homogeneous Sovereign Debt Ratings

Money manager uses its own analysis to assess country risk.

Credit rating companies are distorting capital markets by assigning the same debt ranking to countries from Italy to Thailand and Kazakhstan, according to BlackRock Inc., the world’s biggest money manager.

While 23 countries share the BBB+ to BBB- levels assessed by Standard & Poor’s, the lowest investment grades, up from 15 in 2008 at the beginning of the financial crisis, their debt to gross domestic product ratios range from 12 percent for Kazakhstan to 44 percent for Thailand and 126 percent for Italy, International Monetary Fund estimates show. The cost of insuring against a default by Italy, ranked BBB+, over the next five years is almost triple that for Thailand, which has the same rating.

For BlackRock, which oversees $3.7 trillion in assets, the measures are so untrustworthy that the firm is setting up its own system to gauge the risk of investing in government bonds. This year, the market moved in the opposite direction suggested by changes to levels and outlooks 53 percent of the time, data compiled by Bloomberg show.

“The rating agencies were very, very slow to the game,” Benjamin Brodsky, a managing director at BlackRock International Ltd., said in a Nov. 23 interview from London. “They all came after the fact. For us, this is not good enough.”

Since S&P cut the U.S. to AA+ from AAA on Aug. 5, 2011, yields on the benchmark 10-year Treasury note have fallen to 1.79 percent from 2.56 percent. After France was downgraded on Jan. 13, 10-year yields fell to 2 percent from 3.08 percent.

Ratings companies, the arbiters of creditworthiness and the likelihood of default by governments and companies in the $46 trillion global debt market, are coming under more scrutiny from regulators and investors.

When S&P downgraded the U.S., a Treasury official said the company had made a $2 trillion error. France’s top central banker said Moody’s Investors Service’s ranking is wrong. Russia’s deputy finance minister said S&P and Fitch Ratings exaggerated its weaknesses relative to higher-rated countries.

A court in Australia found Nov. 5 that S&P misled investors during the financial crisis that began in 2007. Regulations being written under the U.S. Dodd-Frank law may ban government entities from using ratings to price bonds.

Moody’s said on Dec. 17 that it plans to change the methodology for sovereign rankings, putting more importance on economic growth. The unit of New York-based Moody’s Corp. is seeking market feedback to help its system become more transparent and “forward-looking,” according to the statement.

Argentine Risk

BlackRock started compiling its own Sovereign Risk Index to measure countries’ creditworthiness in June 2011. The latest quarterly update in October rates Spain, Ireland and Italy similar to Argentina and Venezuela, among the 10 most risky countries. S&P puts Argentina, which defaulted on its debt in 2001, at B-, six levels below Spain. Venezuela is B+, six grades below Italy and Ireland.

The New York-based fund manager sorts countries based on their willingness to pay debts, their access to external funding, the strength of their finance industries and fiscal metrics such as debt-to-GDP, according to Brodsky. The index shows Malaysia and Russia rank similar to the U.S., while the Philippines is no riskier than France and the U.K.

“Ratings should be evaluated on the basis of their correlation over time with defaults, not with short-run movements in market prices,” John Piecuch, a spokesman for S&P, wrote in an e-mail response to questions from Bloomberg on Dec. 6. “Ratings and market indicators of creditworthiness often diverge, because they are generated by fundamentally different processes and can be driven by very different factors.”

The number of countries rated in the BBB category grew as S&P cut European nations such as Spain that are mired in the three-year-old debt crisis and promoted developing nations, including Colombia, from below investment grade. Those ranked A- or above shrunk to 43 from 52 since 2008, according to data compiled by Bloomberg.

Gary Jenkins, founder of Swordfish Research Ltd. based outside of London, said analyzing sovereign credit is becoming more difficult as policy makers and politicians increase intervention in markets.

“It’s not like analyzing cash flows and gearing,” Jenkins, a former head of fundamental credit strategy at Deutsche Bank AG, said by phone from Amersham, England on Nov. 16. “When it comes to European sovereigns they have no more real insight into what may happen than anyone else does. It is educated guesswork. That’s all it is.”

Bond spreads have moved in the opposite direction from what the companies suggested in 53 percent of rating or outlook changes for countries from France to South Korea since February, according to data compiled by Bloomberg. Over the past 38 years, yields have gone the opposite way about half the time for more than 300 issues.

U.S. and French bonds have rallied since the countries were stripped of their top grades.

The companies “quite accurately rank sovereign credit risk” and “they should not be expected to be consistent with specific default probabilities,” according to an IMF study published in October 2010. All 14 sovereign defaults between 1975 and 2009 had been rated non-investment grade one year prior to the event, according to the study.

Most of the “useful informational value” in their assessment comes from their outlook changes, rather than the actual upgrades or downgrades, according to the IMF report.

The companies say they assign ratings based on their assessment of the countries’ ability and willingness to pay obligations, examining criteria such as debt levels, economic growth and political and regulatory stability.

Moody’s Review

The review by Moody’s of its rating performance since 1983 shows that the system has proven to “powerfully” rank-order sovereign default risks, according to the company’s Dec. 17 report. No government has defaulted on its debt within a year of holding an investment-grade rating, according to the report. Countries rated Caa and C, the lowest ranking, had a default rate of 28 percent, compared with 0.6 percent among those in the Ba category, which is the highest speculative grade, the report said.

“There’s nothing in the sovereign statistics to suggest that we are missing credit risk, under- or overestimating sovereign risks in any direction,” Bart Oosterveld, the head of the sovereign risk group at Moody’s in New York, said in a telephone interview on Dec. 6. “Our track record of accurately ranking default risks for sovereigns is really quite good.”

Among the countries in the BBB category that have credit default swaps available, investors are betting that the probability of them missing interest-rate payments by 2018 varies from 23 percent in Spain to 8 percent in Thailand, according to data compiled by Bloomberg.

While S&P has downgraded Italy twice since September 2011, the country is still rated the same as Kazakhstan and Thailand. Italy’s economy probably contracted 2.1 percent this year, compared with growth of 5.4 percent in Thailand and 5.2 percent in Kazakhstan, according to economists surveyed by Bloomberg.

Credit default swaps show Europe’s fourth-largest economy is more risky. The cost to insure Italian debt for five years more than doubled since the end of 2009 to 267 basis points, or 2.67 percentage points, compared with 87 basis points for Thailand and 139 for Kazakhstan, according to data compiled by Bloomberg. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements.

“Rating agencies tend to be a lagging indicator rather than leading indicator,” said Neil Shearing, chief emerging markets economist for Capital Economics Ltd., in a telephone interview from London on Nov. 19. “The danger is giving too much weighting to rating agencies’ opinion.”

Regulators remain divided about how to create a better system. The Dodd-Frank Act, signed into law last year to overhaul financial regulation, requires government agencies to replace ratings with another standard for creditworthiness, without providing details. Basel III international banking standards rely on rankings to gauge risk.

Bank of France Governor Christian Noyer said at a Nov. 30 press briefing in Hong Kong that Moody’s was wrong in its reasoning for revoking the nation’s Aaa rating on Nov. 19, saying the company made a “factual mistake” judging exposure to the debt crisis.

S&P Cuts

After S&P cut its rating on U.S. debt to AA+ from AAA in August 2011, John Bellows, then acting assistant secretary for economic policy at the U.S. Treasury, spotted what he thought was a mistake in S&P’s math. There was no “justifiable rationale” for the downgrade, Bellows wrote on a Treasury blog post. S&P said its decision wasn’t affected by the “change of assumptions.”

Governments, banks and companies pay for assessments of their creditworthiness. S&P, a New York-based unit of McGraw- Hill Cos., Moody’s and Fitch generate about $4 billion in annual revenue with 3,054 analysts ranking 2.52 million securities worldwide, according to data compiled by the Securities and Exchange Commission and Bloomberg.

They also rate borrowers that haven’t asked or paid for them. Fifteen of 128 sovereign ratings at S&P, including the U.S., U.K., France, Switzerland and Argentina, are designated as “unsolicited,” according to a company report dated Dec. 5.

The companies postponed cutting the European countries to junk status because doing so would deprive them of much-needed capital, according to Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania. Some investors, such as pension funds and insurance companies, are barred by regulators from holding high-risk, non-investment grade assets.

“If there are huge incentives for maintaining higher than normal ratings, then that will be the industry behavior,” said Egan in a phone interview on Nov. 19. “If a rating company is not rewarded for being timely and accurate, why in the world they should be timely and accurate?”

Egan-Jones, which competes with S&P, Moody’s and Fitch to rate securities, charges investors, rather than bond issuers, for its opinion on the securities.

“We believe that the marketplace should be open to all business models, provided that all conflicts of interest are identified, disclosed and either eliminated or managed,” Daniel J. Noonan, a spokesman at Fitch in New York, wrote in an e-mail Dec. 6. “In the case of the issuer-pays model, we think that the potential for conflicts of interest is understood and well managed.” Fitch is a unit of Paris-based Fimalac SA.

Rating companies have been slow to recognize improvements in emerging markets, according to David Robbins, who manages a $5.7 billion emerging-market debt fund at TCW Group Inc.

“Many emerging-market countries, certainly by their credit fundamentals, are under-rated compared to developed markets,” Robbins said in a telephone interview from New York on Oct. 22. “The relative credit quality improvement of the emerging market versus developed market probably won’t be over until 2015.”

Russia’s Deputy Finance Minister Sergei Storchak said in June the country should be upgraded at least two steps, a level that would put it above Ireland and Italy. Russia cut its debt to 11 percent of GDP this year from 40 percent in 2002, while Italy’s debt increased to 126 percent from 105 percent, according to the IMF data.

“The issue is the entire finance industry chooses to rely on what is clearly the stuff that doesn’t pass the smell test,” Jan Dehn, a London-based strategist at Ashmore Investment Mangement Ltd., which oversees $68 billion of emerging-market assets, said in a phone interview on Dec. 3. “As long as these perceptions exist in the markets, then you will have misallocation of capital.”

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